HLEG Sustainable Finance – waiting for the Commission’s Action Plan

Today, the EU High-Level Expert Group (HLEG) on Sustainable Finance published its final report. It’s a key step but not the final one – the Commission’s Action Plan on sustainable finance, due early March 2018, is where we will see which recommendations will be transformed into EU policy initiatives.

The final HLEG report (PDF) published on 31 January 2018 widens the scope of sustainable finance beyond environment and climate change to social issues (although governance issues seem to be left out). It also recognizes that a sustainable economy is about more than financial reform, but requires changes in the real economy. More importantly, the Group is advising the Commission beyond what can be achieved in the year remaining before the European Parliament elections. One of the best examples is the recommendation for a process to develop a wide taxonomy of sustainable finance, which would take until 2020 to build. Let’s hope that the support inside the Commission’s services for this agenda is sufficient to ensure sustainable finance continues to receive the political weight it deserves in the 2020-2024 European Commission.

While reservations about some individual recommendations can be made, overall the report is giving a much better and more holistic view of sustainable finance compared to interim report, as well as indicating the kind of initiatives that would be required in the coming years to make the European economy more sustainable, which is very hopeful. Most of the points flagged in our initial assessment (PDF) of the Interim Report (PDF) have been addressed.

A few highlights:

The work on taxonomy is now clearly a long-term process, as noted above. The HLEG report notes that the taxonomy would not be a standard by itself, but be used by standard setters to inform their respective standards. This should help to reduce the political risk attached to a process which ultimately will lead to a European standard, especially if the taxonomy is to be “endorsed” for regulatory and standard setting processes. The Technical Working Committee that the HLEG proposes should also avoid making itself vulnerable to the kind of criticism that has been expressed about the “endorsement” process of accounting standards for EU regulation, which is decided upon by a private industry body (EFRAG).

On investor duties, the Group proposes EU omnibus legislation. While it’s not certain at this stage that the Commission will manage to get a legislative proposal out on time (by May 2018) before the legislative window closes, the HLEG support is helpful. Especially the observation that investor duties need to “cascade through the investment chain” to work properly reflects long-standing frustrations in Brussels around the fragmentation of the investment management chain, partly addressed by the revised Shareholder Rights Directive (SRD) which will start to apply in the summer 2019. The final implementing measures of the SRD will be drafted in 2018 and can still take this recommendation into account.

The recommendation to “upgrade disclosure rules to make sustainability risks fully transparent” has been improved, in particular as it now explicitly recommends using the forthcoming review of the Non-Financial Reporting Directive (NFRD) to facilitate uptake of the recommendations of the Financial Stability Board’s Task Force on Climate-related Financial Disclosure. However, the report stops short of recommending these disclosures be mandatory, suggesting comply or explain mechanisms instead. The European internal market (Capital Markets Union!) would benefit from mandatory comparable disclosure, and the HLEG report seems to echo complaints by the industry that disclosure is costly but not useful to society (“disclosure in a vacuum“). Let’s hope the Commission is bolder on this one when reviewing the NFRD by the end of this year.

The Group also recommends the creation of an “eco-label” for investment products targeting the green transition, which raise some major concerns. First, a label assumes that consensus can be found about minimum standards to which the label would apply – this is a political process that requires someone to take political responsibility for defining or endorsing a set of minimum standards, and take the blame if the label does not meet citizens’ (subjective) expectations afterwards (e.g. the CE-marking which is often misinterpreted as a safety label by consumers). But most importantly, a voluntary green label does NOT guarantee fresh money flowing to the societal transition we need. Fund managers have already started to identify parts of their existing portfolio that can be marketed as ESG/SRI funds, with investors in these funds believing falsely believing that they are helping to finance a (green) transition. It’s pretty much like paying for green electricity but getting the same power as your neighbours.

The same risk applies to the recommendation to create green bond standards (page 31), which will (by definition) include “existing eligible green projects“. That’s pretty incompatible with the objective of the label as stated on page 30, which is to “encourage a substantial increase in investment in green projects and activities“. And what are the definitions anyway? There will be guidance on “high level categories” but does that mean student housing is always good and transport infrastructure always bad? What about a railway being used to sustainably transport coal to a non-sustainable coal-fired power plant (one of the EFSI 1 projects)?

The report also comes up with additional cross-cutting recommendations. Although it’s difficult to assesses how likely the Commission is to take these on board in the Action Plan, some are worth mentioning:

The initial recommendation to revise quarterly accounting standards for insurers and others to deal with the valuation swings caused by mark-to-market rules, seems to have been successfully challenged by some of the members of the group, and the report is now far more balanced about the political trade-offs that such changes would entail.

At some point, the Group’s draft suggested that the Commission research whether “liquidity in financial markets comes at the cost of high short-term trading“, suggesting that there is a socially optimum to liquidity and that extreme liquidity in terms of volume and reduced bid-ask spreads does not really help long-term investors. This is a refreshing view compared to some of the Commission and industry positioning we’ve seen in the context of MiFID II on high-frequency trading and commodity derivatives, and it’s a shame that it has not made it into the final report.

Finally, compared to earlier drafts and following the Commission’s announcement at the One Planet Summit (Paris, December 2017), the HLEG is now taking the introduction of a green supporting factor for granted, listing “key conditions for a green supporting factor to be effective” instead of debating pros and cons (this article explains why we should be extremely cautious promoting a green factor).

This wind of change is perhaps surprising to some, but confirms that the main document that will drive EU sustainable policy is the one that comes out in March 2018: the Commission’s Action Plan.